Variable Annuity with GMWB: surrender or not, that is the question

TL;DR

This paper analyzes the impact of surrender options on the pricing of GMWB variable annuities, comparing optimal, static, and bang-bang strategies, and finds that surrender features can significantly increase contract value.

Contribution

It extends an existing algorithm to include surrender options in GMWB pricing and compares different policyholder strategies, revealing the value added by surrender features.

Findings

Bang-bang strategy closely approximates optimal strategy in price.

Surrender option significantly increases GMWB contract value.

No-withdrawal option adds minimal value to the contract.

Abstract

Under the optimal withdrawal strategy of a policyholder, the pricing of variable annuities with Guaranteed Minimum Withdrawal Benefit (GMWB) is an optimal stochastic control problem. The surrender feature available in marketed products allows termination of the contract before maturity, making it also an optimal stopping problem. Although the surrender feature is quite common in variable annuity contracts, there appears to be no published analysis and results for this feature in GMWB under optimal policyholder behaviour - results found in the literature so far are consistent with the absence of such a feature. Also, it is of practical interest to see how the much simpler bang-bang strategy, although not optimal for GMWB, compares with optimal GMWB strategy with surrender option. In this paper we extend our recently developed algorithm (Luo and Shevchenko 2015a) to include surrender option in GMWB and compare prices under different policyholder strategies: optimal, static and bang-bang. Results indicate that following a simple but sub-optimal bang-bang strategy does not lead to significant reduction in the price or equivalently in the fee, in comparison with the optimal strategy. We observed that the extra value added by the surrender option could add very significant value to the GMWB contract. We also performed calculations for static withdrawal with surrender option, which is the same as bang-bang minus the "no-withdrawal" choice. We find that the fee for such contract is only less than 1% smaller when compared to the case of bang-bang strategy, meaning that th "no-withdrawal" option adds little value to the contract.